China Plays Long Game With Ruble Deal

By

Wayne Arnold

Dec. 29, 2014 8:35 pm ET

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What new devilry is this? While all of Christendom was recovering from a day over-indulging on eggnog, figgy pudding and antics worthy of that new quadcopter drone, China was busy extending its financial tentacles. On Dec. 26, the currency boffins at the People’s Bank of China announced that, starting this week, they would begin allowing the trade of derivatives for companies and investors to bet on the exchange rate between Russia’s ruble and China’s currency, the yuan, with no U.S. dollars between them as chaperone.

Conspiracy theorists weren’t so besotted with Yuletide cheer that they didn’t sit up and cry foul. This, they bellowed, was a clear instance of China stepping in to lend a helping hand to its old Cold War comrade and prevent Western sanctions (and cheap Saudi crude) from breaking Russia’s back. And just when they seemed so close to convincing Moscow into pushing its proxies in eastern Ukraine into a peace deal and its Middle-Eastern puppet Syria to the negotiating table, too.

The derivatives deal comes on the heels of an October agreement allowing Russia’s central bank to borrow up to 150 billion yuan ($24.4 billion) using swap agreements. Some commentators called that deal a lifeline to Russia as the ruble slid. The Russian currency has lost half of its value this year, forcing Moscow to take extreme measures to avoid a balance of payments crisis, including raising the benchmark interest rate to 17% and ordering Russia’s biggest exporters to cash in their dollars for rubles.

It may therefore seem like Beijing is trying to turn Russia’s crisis into its own opportunity -- to sew a silk purse from Moscow’s ear. But the Chinese panda may not exactly be scratching the Russian bear’s back here. Opening up a credit line in yuan to Moscow doesn’t begin to solve Russia’s immediate problem: oil prices are too low relative to its imports and overseas debt. Unless Russia can substitute trade with the West for trade with China, the balance of payments risk remains as long as the ruble is in free-fall. All the yuan in the world can’t help Russia if it runs out of dollars.

Indeed, China is only offering a long-term solution to Russia’s immediate dilemma. Opening a swap line and allowing for the trade in ruble-yuan forwards and swaps makes it easier for Russia to conduct its foreign trade in yuan instead of U.S. dollars or Euros. As China opens its own economy further to foreign investors, it may someday make sense for central banks like Russia’s to hold yuan in their reserves, just as they now holds dollars and to a lesser extent Euros, yen and gold. When that happens, a soaring dollar wouldn’t necessarily be game-over for Russia’s economy. Until Russia kicks its crude-export habit, however, falling oil prices will hurt in any currency.

The advantages to China of internationalizing the yuan are much clearer. As Citigroup notes, China accounts for roughly 11% of global currency trades, but less than 2% of those trades are settled in yuan. Earning dollars was awesome when China was using cheap exports to fund its rise from poverty. But it’s now a middle-income nation with almost $4 trillion in predominantly dollar reserves. With no other country’s financial markets big enough to absorb even a fraction of that, most of those greenbacks go right back to the U.S. to be invested in U.S. Treasuries and quasi-government agency debt. U.S. Congress members may grouse about America being in hock to China, but the truth is that China is at the mercy of its giant, heavily indebted trading partner.

Like any yield-hungry baby boomer staring into the face of retirement, China’s aging economy is getting to the point where America’s rising debt, low interest rates and weak currency do more harm than good. China has tried to diversify to some extent into higher-yielding investments. But it can’t do too much without taking on risky emerging-market risk or torpedoing the value of its existing U.S. holdings as it tries to sell them off.

Its solution: gradually convince the world to use its own currency instead. That way China can accrue the benefits of a strong currency as it moves from being a dynamic exporter to an aging importer, and can even borrow abroad in its own currency. China won’t make any quick moves: the downside of having the world use your currency, as the U.S. Federal Reserve has learned, is that you can’t control what happens to money beyond your borders. To some extent, that robs a central bank of control over domestic interest rates. Oh, and you have to have open financial borders, something else China isn’t yet completely comfortable with.

So China’s financial feelers to Russia aren’t part of an urgent conspiracy to foil Western sanctions. They’re part of a more gradual, profound plot: to topple the U.S. dollar as the world’s reserve currency.

The Russians aren’t the only ones involved, either. Beijing already has swap arrangements with a long list of co-conspirators in Southeast Asia and in November sealed a swaps deal with Australia. On Christmas day of 2011, it signed a swap agreement with regional rival Japan. And in June, it signed an MoU to get advice on currency derivatives from none other than the Chicago Mercantile Exchange.

As one former U.S. Treasury official told me a few years ago, no one asked China to buy up all those dollars. If internationalizing the yuan is a conspiracy, it seems everyone is in on it.

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